Copyright, 1997, Economic Security Planning, Inc. A portion of the disclosure of this patent document contains material which is subject to copyright protection. The copyright owner has no objection to reproduction by anyone of the patent document or the patent disclosure, as it appears in the U.S. Patent and Trademark Office patent file or records, but otherwise reserves all copyright rights whatsoever.
Not Applicable
This invention relates to a method of and system for economic security and financial planning and, more particularly, to a method and system which utilizes consumption smoothing in combination with liquidity constraints and life insurance purchasing requirements.
Traditional financial planning methods are based on a targeted liability approach. Under this approach, households are asked to specify their particular needs, called liabilities. Typical liabilities include post-retirement income or expenditures, payment of college tuition, and the down payment for a house. Next, saving and insurance amounts are calculated to meet these liabilities. Households are advised to meet these targeted liabilities by saving each year the constant amount needed to advance-fund each liability.
The traditional method, which is used in current financial planning software packages, has many flaws. First, it does not directly and immediately assist households in smoothing their consumption over their life spans. Second, the method lacks a reasoned basis for setting its principal targets, namely the levels of income or expenditures desired after retirement and after the death of a spouse. Since traditional financial planning methods and software provide no clear criteria for setting the most important targetxe2x80x94namely post-retirement income, financial planners and other users typically fall back on conventional and arbitrary rules of thumb, such as xe2x80x9c70 percent of pre-retirement labor earnings.xe2x80x9d In other instances, the household is asked to supply these targets, which amounts to asking household members to plan for themselves.
Such targets can lead to highly inappropriate recommendations. For example, for households with high assets relative to labor earnings, a 70 percent replacement rate is likely to be much too low. Current financial planning software recommends that such households save relatively little (consume relatively a lot) prior to retirement. Consequently, those high-asset households that follow these recommendations will experience a significant decline in their living standard after retirement. For households with low net wealth relative to labor earnings, a 70 percent retirement income is likely to be too high. If such households follow the recommendations of current financial planning software, they will save relatively large amounts (consume relatively little) prior to retirement only to end up with a much higher living standard after retirement.
Financial planning software programs that form their targets by asking households to specify what they want to spend on particular commodities in retirement present a similar problem. If the household specifies too high a level of post-retirement consumption, it will be forced to cut back its current consumption by more than it may desire. If it specifies too low a level of post-retirement consumption, it will be encouraged to undersave.
Current methods for financial planning fail to adjust properly for household characteristics and circumstances. For example, they recommend the same amount of current saving to meet future target liabilities regardless of whether the household composition is expected to change over time, due to the anticipated arrival of new children or the departure of grown children. But it is appropriate for households to save less when, for example, dependent children are present and to save more, for example, when households have temporarily high income.
Traditional financial planning methodologies are not well suited for interpreting quantitative targets in terms of concrete consequences. The resulting recommendations are often highly unrealistic and therefore lack psychological cogency. Households are often told to save when they can least afford toxe2x80x94for example, when dependent children are present, and to spend when they can most afford to savexe2x80x94for example, when earnings are temporarily high. Depending on their circumstances, households may also be led to purchase far too much or far too little insurance.
Currently available methods fail to integrate savings and insurance decisions in a. satisfactory manner. Saving and insurance decisions are highly interdependent. Households that save more do not need to purchase as much insurance through time. Similarly, households that purchase more life insurance through time need to do less precautionary saving to protect against the death of the head or spouse. Traditional financial planning programs make their recommendations for life insurance independently of their recommendations for saving; i.e., they do not simultaneously solve for optimal saving levels and life insurance holdings.
Current financial planning does not fully integrate contingent planning in its life insurance calculations. For example, it does not take into account how the death of a spouse would affect the social security benefits received by his or her widow(er).
Typical financial planning programs fail to properly integrate multiple saving objectives, such as retirement income and college tuition. Instead, each objective is translated into an immediate, fixed saving requirement and these saving requirements are simply added together. But most households do not, and should not, behave this way. For example, they save first primarily for their children""s college and, once they have paid for college, start saving in earnest for their retirement. In practice, experienced financial planners adjust their recommendations to try to compensate for the shortcomings of the traditional financial planning method. But even the most experienced financial planners cannot be assured that they are making the most appropriate adjustments, many of which involve complex calculations that can only be performed by computer.
Typical financial planning programs do not incorporate the limitations on households"" abilities to borrow. Consequently, the current consumption levels implicitly being recommended by current programs (by subtracting current recommended saving from current income) may be infeasible because they would require the household to borrow more that it is able, even to maintain a minimum living standard. For example, if the household has temporarily low income or temporarily high special expenditures and has specified relatively high saving targets, meeting those targets may require borrowing to maintain a minimum living standard, but such borrowing may not be possible.
Current programs do not try to iterate to a smooth path of consumption over the life cycle because this can be a very time-consuming process. This is not surprising given that existing financial planning programs do not take consumption smoothing as their principal objective.
Traditional financial planning does not take into account economies to scale in share living and the associated changes in expenditure needs that arise from changes, over time, in a household""s demographic composition. Similarly, it doesn""t take into account the fact that children typically entail less expenditure relative to adults in order to maintain the same living standard (e.g., childrens"" shoes cost less than adults"" shoes).
These disadvantages of existing financial planning methods lead to saving and insurance prescriptions that often produce dramatic reductions or increases in a household""s consumption after retirement and in the event of the death of a spouse; i.e., they disrupt, rather than smooth, consumption over the life cycle.